Essays on international portfolio allocation
and risk sharing

Abstract

This thesis contributes to the theoretical literature that analyses the link between
international asset trade and international risk sharing. Despite the massive increase
in cross-border asset trade since the 1990's, consumption risk sharing across countries
remains limited. In standard international business cycle models, efficient risk sharing
requires that consumption should be higher in the country where it is cheaper to
consume, implying a high positive correlation between relative consumption and real
exchange rate, which is strongly rejected in the data. Recent contributions show that
it is possible to account for this so-called 'consumption-real exchange rate anomaly'
in models with goods and financial market frictions where international asset trade
is restricted to a single non-contingent bond.
Chapter 1 analyses whether this class of models can account for the anomaly
under a richer asset market structure where agents can trade in domestic and foreign
currency bonds. Even such a small departure from the single bond economy implies
too much risk sharing compared to the data although the number of assets that can be
traded is less than the number of shocks affecting each economy. Introducing demand
shocks alongside sector-specific productivity shocks can improve the performance of
the model only under specific parameter and monetary policy settings. Chapter
2 extends this analysis to study the implications of international trade in equities,
portfolio transaction costs and recursive utility.
Chapter 3 studies the interaction between monetary policy and foreign currency
positions in more detail. Different monetary policy regimes can lead to different
foreign currency positions by changing the cyclical properties of the nominal ex-
change rate. These external positions, in turn, affect the cross-border transmission
of monetary policy shocks via a valuation channel. The way export prices are set
has important implications for optimal foreign currency positions and the valuation
channel when prices are sticky and financial markets are incomplete.
Chapter 4 compares the international transmission of uncertainty shocks under
alternative asset markets with an emphasis on the behaviour of net foreign assets,
exchange rate and currency risk premium and shows that a model with restricted asset
trade performs better than a model with complete financial integration in matching
certain aspects of the data regarding the dynamics of these variables in response to
increased macroeconomic uncertainty.